Tools with Rules: Those Fantastic IRAs

Because time is money and money buys time, it’s important that Millennials and Gen-Zers begin saving (and investing) early in life in order to optimize The Amazing Power of Compounding.

Because time is money and money buys time, it’s important that Millennials and Gen-Zers begin saving (and investing) early in life in order to optimize The Amazing Power of Compounding. Have I mentioned that before? Let's flesh out a couple of extraordinary wealth-building tools for our youngsters!

‍Time Is Money

Members of my target generations who are not yet saving have already lost valuable time. Still, as I have pointed out time and again, it’s never too late, but early is best. Almost nothing matters as much in personal finance as deciding NOT to violate the fundamental principle of saving early in life. If you violate this principle, you’ve helped neuter The Amazing Power of Compounding. But enough sermonizing.

Youngsters And Earned Income

Most investors are familiar with Individual Retirement Accounts (IRAs) – and understand that IRAs represent important tools for young investors, who because they are young, can take maximum advantage of time and its supportive co-conspirator, compounding.

Surprisingly, many parents don’t know that youngsters, regardless of age, can contribute to IRAs, but, with rare exception, only if they have earned income. That, of course, is a big “if” especially when paired with a big “maybe” – will a youngster with earned income choose to contribute money to an IRA versus spending it on movies, video games or some early-stage million-dollar habit? More about this later…once we get Grandpa involved.

Both types of IRAs – Roth and Traditional – are suitable for children. Their difference stems from when the individual pays taxes on contributions to the plan. In short, a Traditional IRA is funded with pre-tax dollars, whereas, a Roth IRA is funded with after-tax dollars. Regarding Traditional IRAs, taxes are paid when money is withdrawn from the plan beginning no later than age 72 (at the then-applicable personal tax rate).

The Appeal Of Roth IRAs

In both Traditional and Roth IRAs, money accumulates tax free. But here’s the appealing kicker of a Roth. If and when Roth withdrawals begin decades later, no income tax whatsoever is due. And the Roth is not plagued by Required Minimum Distributions (RMDs) that begin at age 72 for Traditional IRAs – subject, of course, to Uncle Grabby’s IRS rule changes. And he’s capable of that on a whim, re the recent SECURE Act, which curtailed the tax benefits of “stretch” IRAs. Requiring annual payouts from Roth IRAs was not included in this most recent legislation, but what about the next Congressional whim?

Speaking of Uncle Grabby, always be mindful of tax considerations. The contributing child may be required to file a tax return if his or her income exceeds a certain amount. If the child earns less than this amount, he or she will likely be in a 0% tax bracket – and will not benefit from an up-front tax deduction associated with Traditional IRAs. In that case, it makes sense to focus on a Roth, the IRA of choice (in my opinion) for children with limited income.

A Wise Move

As suggested earlier, creating an IRA for an eligible youngster is a wise move. Because of the youth factor, The Amazing Power of Compounding will work its magic over a longer period, and the results will be – well – truly amazing. But remember, the child must keep a Roth until age 59½ for all withdrawals to be tax-free. (Prior to age 59½, Roth contributions, but not investment earnings, can be withdrawn for any reason without tax or penalty under existing Uncle Grabby rules).

Don’t Forget Gramps

In summary, children, regardless of age, can contribute to an IRA if they have earned income. Others (including Gramps) can contribute to the child’s IRA, too, as long as the amount of the child’s earned income is not exceeded. By the way, a minor’s IRA must be set up as a custodial account by a parent or other adult.

Also, there are opportunities to contribute to an IRA without a job! We’ll talk more about that next week.